Financial Risk Management Market Risk Measurement 1 — Questions and Answers
Question 1: What does Value at Risk (VaR) measure?
- The maximum loss not exceeded at a given confidence level over a specified period (Correct answer)
- The average loss over a one-year horizon
- The total market capitalization of a portfolio
- The minimum expected return of a portfolio
Correct answer: The maximum loss not exceeded at a given confidence level over a specified period
VaR estimates the maximum potential loss at a specified confidence level (e.g., 95% or 99%) over a defined time horizon.
Question 2: Which method of VaR calculation uses the actual historical returns of a portfolio?
- Monte Carlo simulation
- Parametric (variance-covariance) method
- Historical simulation (Correct answer)
- Stress testing
Correct answer: Historical simulation
Historical simulation applies past observed returns directly to the current portfolio to estimate the VaR distribution without assuming normality.
Question 3: What is the main limitation of VaR as a risk measure?
- It is too complex to calculate
- It does not capture losses beyond the confidence threshold (tail risk) (Correct answer)
- It always overstates losses
- It cannot be applied to derivatives
Correct answer: It does not capture losses beyond the confidence threshold (tail risk)
VaR tells you nothing about the severity of losses that exceed the confidence level, which is why Expected Shortfall (CVaR) is often used as a complement.
Question 4: Expected Shortfall (ES), also called CVaR, measures which of the following?
- The most likely loss in a normal market day
- The average loss given that the loss exceeds the VaR threshold (Correct answer)
- The standard deviation of daily portfolio returns
- The probability that a loss exceeds a specified level
Correct answer: The average loss given that the loss exceeds the VaR threshold
Expected Shortfall is the mean of all losses that fall beyond the VaR cut-off, providing a fuller picture of tail risk.
Question 5: Delta-normal VaR assumes portfolio returns follow which distribution?
- Poisson distribution
- Log-normal distribution
- Normal (Gaussian) distribution (Correct answer)
- Uniform distribution
Correct answer: Normal (Gaussian) distribution
The delta-normal (parametric) approach linearizes portfolio sensitivities and assumes returns are normally distributed to compute VaR analytically.
Question 6: Which risk metric is required by the Basel III/IV internal models approach to replace VaR?
- Conditional VaR (CVaR)
- Expected Shortfall (ES) at 97.5% (Correct answer)
- Stress VaR at 99%
- Maximum Drawdown
Correct answer: Expected Shortfall (ES) at 97.5%
Basel IV's Fundamental Review of the Trading Book (FRTB) replaces 99% VaR with 97.5% Expected Shortfall to better capture tail risk.
Financial Risk Management Market Risk Measurement 1
What does Value at Risk (VaR) measure?